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Saturday, 13 August 2011

The Death Cross Is Back

Two things should stick out at the reader upon perusing the chart below. First, inversely from top to bottom, what is rather disturbing is that the average trade block size in ES has tumbled over the past week, which we believe is indicative of the massive deleveraging hedge funds have been forced to undergo in order to not be torn to shreds by the massive volatility in the markets in the past 10 days. It also means that the marginal impact of a far smaller trade is proportionally higher than it would have been back in May when the average block size was at the highest for 2011, concurrent with NYSE margin debt and net leverage hitting fresh post-Lehman highs. As such it means that we should expect to see a 50 S&P point yoyo market for quite a bit or until such time as hedge funds relever once again, and take the marginal pressure off the momentum creating and chasing HFT machines. Another notable observation: the 50 DMA is about to drop below the 200 DMA. Another name for this phenomenon? The Death Cross. The last time this happened was back in July 2010, just weeks before the first occurrence of the Hindenburg Omen back in August 2010 which pushed the market to its lows for the year, which, among many other factors forced Bernanke to launch QE3 two weeks later. Is the Death Cross the precursor to a comparable chain of events this time around? We shall see as soon as August 2th.

In the meantime, for those wondering about the predictive power of the Death Cross, we refer to MarketWatch's Mark Hulbert who compiled the following table of market performance following the appearance of the technical formation:

His follow up commentary:

The market does tend to turn in below-average performances following death crosses; indeed, the differences in the table are significant at the 95% level that statisticians often use to determine if a pattern is genuine.

If I ended my analysis at this point, the data would point strongly in favor of interpreting the stock market's recent death cross as another strike against an already beleaguered market.

But, as Paul Harvey used to say, there's the rest of the story.

It turns out that the death cross has had a mediocre track record at best over the last two decades. To be sure, it's had some great recent successes -- such as the one that occurred in December 2007, very early in the 2007-2009 bear market. But there have been a number of other failures -- such as one that occurred in October 2005, in the middle of the 2002-2007 bull market.

Overall, in fact, there has been no statistically significant difference since 1990 between the average performance following death crosses and all other market sessions.

What has changed since 1990 to make this indicator less "predictive"?

LeBaron speculates that moving averages might have been sabotaged by too many investors trying to follow then.

Ownership of personal computers skyrocketed in the late 1980s and early 1990s, and coupled with cheap online databases, those PCs enabled a much larger group of investors than ever before to discover and quickly exploit the moving average. A dramatic lowering in transaction costs at about the same time made it much easier for investors to trade on signals generated by moving averages.

The bottom line? The weight you put on the stock market's recent death cross depends on whether you think the last two decades are a mere exception to the long-term rule -- or if, instead, you believe that something indeed has permanently changed.

Or, another way of saying it is that in the past 20 years, courtesy of the great moderation, none of the traditional indicators have worked as the one and only primary driver of market performance has been central planning in the form of cheap and relentless market liquidity.

Want to know what the market does tomorrow? Ask the Chairman (if you have access of course).

Everyone else may just take their yoyo odds to Vegas. The scenery is far better.